Thursday, June 14, 2007

A Veto Threat

Congratulations! You are the proud owner of a new gas station in Boca Raton, Florida. You sell gasoline at this week’s average price in Florida: about $3.00 for a gallon of regular grade. Fun gas station owner fact: you make a pre-tax profit of only about 3 cents per gallon. (For comparison, taxes are in the range of 50 cents per gallon in Florida.) You make most of your profit from foot traffic in your convenience store, selling things like bottled water and soda, chips and candy, lottery tickets, and cigarettes. This means your profit motive drives you to focus first on keeping foot traffic coming into your convenience store.

Now a hurricane hits. Let’s say it takes out the power that supplies some fuel terminals, drastically reducing the gasoline flows that supply gas stations in South Florida.

Economists would call this a negative supply shock. The supply of gasoline in Florida has suddenly declined, and so the price you will have to pay to buy gasoline for your station is jumping by, say, $1 per gallon. Also, you now have serious concerns about getting your tanks refilled. In normal times, a supply truck might visit you once a week. Now it looks like it will be once every 10-12 days, and it’s unpredictable.

Should you raise your prices? Your cost of goods is about to jump by a third. Demand has spiked. Some people are driving to leave town and need to fill up. Others are afraid that gasoline will run out, and so they fill up just in case.

If you keep prices where they are, the increased demand will almost certainly cause you to run out of fuel before the truck shows up in 10-12 days. You’ll have to shut down, and you’ll have zero foot traffic in your convenience store (and therefore zero profits).

Or you can raise your price. If you raise your price, then some drivers won’t be able to afford it, and only those who value gas at, say, $4/gallon will buy. The reduced demand from the higher price will counterbalance the increased demand from the hurricane aftermath. You’ll sell fewer gallons each day, but you’re less likely to run out of gas 10 or 11 days from now. Your store will therefore remain open until the truck arrives to refill your tanks, and you’ll make profits from foot traffic in your store (even though drivers will be buying fewer chips and lottery tickets).

Now let’s assume that H.R. 1252, the bill recently passed by the House on a 284-141 vote, has become law. (Thankfully, it has not.) That bill includes the following language:

It shall be unlawful for any person to sell, at wholesale or at retail in an area during a period of an energy emergency, gasoline … at a price that –(A) is unconscionably excessive;and(B) indicates the seller is taking unfair advantage of the circumstances related to an energy emergency to increase prices unreasonably.

Because of this (hypothetical) law, you have to worry that the Federal Trade Commission in Washington, DC, or the Florida State Attorney General (both of whom are given new enforcement powers) will decide that a $1 price increase is “unconscionably excessive,” or that your price increase is “unreasonable.”

You’re confident you could make a strong case that neither of those provisions hold, but what do you know? You’re a gas station owner, not an antitrust attorney. Let’s also assume that some local elected officials are on TV saying they are “on the lookout for price gougers,” and they are insisting that the Florida AG “use his authority to the fullest extent possible.” How are you to determine whether any of several officials, each of whom faces various bureaucratic, political, and public pressures, will decide that a 25 cent, 50 cent, or $1 price increase is “unconscionably excessive” or “unreasonable”?

If you make the wrong decision, you could pay a fine of up to $2 million, or go to prison for up to 10 years.

What do you do? Do you buy gasoline for $1 more per gallon, and raise your prices by the same amount, risking 10 years in prison? Of course not. You shut down until your supply price drops enough that you’re willing to take the risk. The “Federal Price Gouging Prevention Act” discourages you from selling gas when it’s needed most.

Natural disasters do not destroy the laws of economics. Markets allocate scarce goods to those who value them the highest. In a disaster, someone who must get out of town might be willing to pay $4 or $5 per gallon. A soccer mom with 3/4 of a tank might decide not to buy gas at that price. Economists call that an efficient solution. High gas prices are unpleasant. But long gas lines can be worse. If you’re not old enough to remember the gas lines of the 1970s, ask someone to tell you about "odd and even days."

We saw gasoline markets working after the 2005 hurricanes, which temporarily knocked out close to 30% of US oil production and gasoline refining capacity. Gasoline prices spiked upwards, but after power was restored, gasoline quickly became available. Unsurprisingly, the incentives created by high prices sent a signal to the market, attracting supplies to the US, and particularly to the East Coast and Gulf Coast regions. Tankers on their way to other parts of the world (like Europe) changed course to the US, and additional supplies came from the Far East. Supply in the stricken area increased, and prices fell. Markets work.

Obviously, we don’t condone illegal pricing practices. The FTC already has the authority to prosecute unfair anti-competitive behavior in a carefully defined and economically meaningful way. So if suddenly you’re one of only two gas stations in town, and if you collude with the other guy to keep your prices artificially high, then you’re breaking an existing law.

This bill imposes a price control on gasoline. It’s not a traditional price control, in which the government says “you may not charge more than $3.50 per gallon,” but it has a similar effect. The control comes from giving the government the power to throw you in jail if you charge “too much”, as determined by someone in the government. It is exacerbated by the use of ambiguous terms like “unconscionably excessive” and“unreasonably.” Price controls have damaging side effects.

The bill is based on a largely incorrect presumption that, when a disaster hits, price increases are the result of evil business owners taking advantage of the situation. The real reason in almost all situations is more mundane: supply decreases and/or demand increases. In a competitive market, when either of these things occurs, prices go up to balance supply and demand.

The economic inanity is not limited to the House of Representatives. My White House friend notes that "similar language is included in the bill that’s now on the Senate floor. So what we said about H.R. 1252 also applies to the 'anti-price gouging' title of the Senate energy bill."

About Me

I am a professor and chairman of the economics department at Harvard University, where I teach introductory economics (ec 10). I use this blog to keep in touch with my current and former students. Teachers and students at other schools, as well as others interested in economic issues, are welcome to use this resource.